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The best things in life are free... Free goods provide a special challenge for economic analysis Most goods in our economy are allocated in markets… …for these goods, prices are the signals that guide the decisions of buyers and sellers.

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The best things in life are free... When goods are free, people do not have the incentive to produce. Market forces are absent. Government must step in.

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The Different Kinds of Goods When thinking about the various goods in the economy, it is useful to group them according to two characteristics: u Is the good excludable? u Is the good rival?

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The Different Kinds of Goods uExcludability u People can be prevented from enjoying the good. u Laws recognize and enforce private property rights.

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The Different Kinds of Goods u Rivalness u One persons use of the good diminishes another persons enjoyment of it.

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Types of Goods u Common Resources u Are rival but not excludable. u Natural Monopolies u Are excludable but not rival.

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Types of Goods

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The Free-Rider Problem A free-rider is a person who receives the benefit of a good but avoids paying for it.

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The Free-Rider Problem uSince people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. uThe free-rider problem prevents private markets from supplying public goods.

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Solving the Free-Rider Problem uThe government can decide to provide the public good if the total benefits exceed the costs. uThe government can make everyone better off by providing the public good and paying for it with tax revenue.

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Some Important Public Goods u National Defense u Basic Research u Programs to Fight Poverty

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Are Lighthouses Public Goods?

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Cost-Benefit Analysis uIn order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good. uCost benefit analysis estimates the total costs and benefits of a good to society as a whole.

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Cost-Benefit Analysis u A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole. u It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs. u The value of life, the consumers time, and aesthetics are difficult to assess.

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Common Resources Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them.

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Common Resources Common resources are rival goods because one persons use of the common resource reduces other peoples use.

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Tragedy of the Commons The Tragedy of the Commons is a story with a general lesson: When one person uses a common resource, he or she diminishes another persons enjoyment of it. u Common resources tend to be used excessively when individuals are not charged for their usage. u This creates a negative externality.

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Examples of Common Resources uClean air and water uOil pools uCongested roads uFish, whales, and other wildlife

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Importance of Property Rights The market fails to allocate resources efficiently when property rights are not well-established (i.e. some item of value does not have an owner with the legal authority to control it).

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Importance of Property Rights When the absence of property rights causes a market failure, the government can potentially solve the problem.